The Short Ratio as a Stock Sentiment Indicator

This article was originally published by Zacks.com.

This week's screen looks at a market sentiment indicator called the short ratio to find new stock picks.

The short ratio is the number of shares sold short (short interest or bets that the stock will go lower in price) divided by the average daily volume. This is also sometimes referred to as the "days to cover" ratio because it tells approximately how many days it will take short-sellers to cover their positions if good news sends the price higher.

The higher the ratio, the longer it would take to buy back the “sold” (borrowed) shares. And in theory, the more short positions there are to cover, the stronger the short-covering rally would be.

How to use It

Many people who use the short ratio indicator like to look for the number of "days to cover" to be more than eight to 10 days. It's generally believed that a short ratio of that size could prove difficult to cover and therefore trigger a strong rally on any hint of an upswing. (My personal preference is to take that into consideration, but also compare it to the industry's average ratio and the stock's own historical ratio.)

And while I wouldn't recommend using just the short ratio as the “be all to end all” of screening items, I do think it can be a great tool for helping define great opportunities.

Short ratio and consolidation

Sometimes when I'm looking for stocks that have been in a lengthy consolidation, I'll look for those stocks with high short ratios.

Why?

Because consolidation ranges are basically areas of market indecision. Bets are being made by both bullish and bearish investors. Stocks that are going back and forth near their price highs with a growing short ratio shows that ever-increasing bets are being made on prices going lower.

However, if the stock breaks out to the upside, properly positioned bulls will more than likely add to their winnings, undecided traders will now be convinced to get long and shorts will have to scramble to cover their bearish bets. This can be an explosive situation.

Short ratio and bottom picking

This can be used quite effectively for bottom fishing too.

When a stock is getting battered and pundits are wrangling over whether it's the bottom or not, you should pay close attention to the short ratio.

Of course, there has to be a reason for a stock to move higher. So seeing an improving fundamental outlook is important.

But when lopsided market sentiment seems to be at its worst (reflected in investors' buying and selling) the short ratio can be just the thing to uncover extremes.

For example:

For beaten down stocks you can search for companies near their 52-week lows with increasing short ratios. Or better yet, look for short ratios above their average values or even ones that are at (or near) their historical highs.

Short ratio and uptrends

For stocks moving higher, try looking for historically high short ratios for stocks up 20% or more (new uptrend) or that have just rallied past an important moving average like the 50- or 200-day average. (Funds will often pile in at those points. So a large short ratio could propel the market significantly higher as huge buyers bid the market up while panicky shorts chase it even higher just to get out.)

The screen I'm currently running focuses in on those kinds of companies: stocks in solid uptrends with relatively large short ratios that could send the stocks soaring if the shorts are forced to buy those shares back. The parameters to this week's screen are:

• % price change — last 12 weeks greater than S&P 500

• Current price/52-week high greater than or equal to .80

(Stocks trading within 20% of their 52-week high.)

• Projected one-year growth rate greater than industry median

• Short ratio greater than 10

(Greater than 10 days to cover.)

• Current short ratio greater than short ratio one month ago

(In other words, the short ratio has increased.)

• Zacks Rank less than or equal to 3

(Strong Buys, Buys, and Holds)

• Current price greater than or equal to $5

• Avg. daily volume greater than or equal to 100,000

Here are five of the companies that made the list this week:

Essex Property Trust, Inc. (ESS)

(11.25 days to cover)

Encore Capital Group, Inc. (ECPG)

(14.24 days to cover)

Manchester United plc (MANU)

(29.53 days to cover)

Eaton Vance Corp. (EV)

(11.17 days to cover)

Valassis Communications, Inc. (VCI)

(34.65 days to cover)

Kevin Matras is a Vice President at Zacks Investment Research, where he is the fundamental stock screening and technical chart patterns expert.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Neither Zacks Investment Research, Inc., Physician’s Money Digest nor the information providers have any liability, contingent or otherwise for the accuracy, completeness, timeliness or correct sequencing of the information or for any decision made or action taken by you in reliance upon the information or “Zacks.com” or “PhysiciansMoneyDigest.com” or for interruption of any data, information or any other aspect of “Zacks.com” or “PhysciansMoneyDigest.com.” The past performance of a mutual fund, stock or investment strategy cannot guarantee its future performance.